Chapter 1

THE ROLE AND

ENVIRONMENT OF
MANAGERIAL
FINANCE


1.1 FINANCE AND BUSINESS





FINANCE
-the art and
science of
managing
money
FINANCIAL SERVICES
-design and delivery of
advice and financial
products to individuals,
business, and
government
MANAGERIAL FINANCE
- duties of the
financial manager in the
business firms
manage the
financial
affairs of any
type of
business -
financial and
nonfinancial
LEGAL FORMS OF BUSINESS ORGANIZATION
owned by one person who operates it for his or her
own profit.
SOLE PROPRIETORSHIP
consists of two or more owners doing business
together for profit.
PARTNERSHIP
artificial being created by law
often called as legal entity and has the powers of an
individual that it can sue and be sued, make and be
party to contracts, and acquire property in its own
name.
CORPORATION
PROPRIETOR
PARTNERS
Articles of
partnership
stock
non-stock
STOCKHOLDERS
MEMBERS
preferred
common
TABLE 1.1a STRENGTHS OF THE COMMON LEGAL FORMS OF
BUSINESS ORGANIZATION
SOLE
PROPRIETORSHIP
owner receives all
profits (sustains all
losses)
low organizational
costs
income included and
taxed on proprietors
personal tax return
independence
secrecy
ease of dissolution
PARTNERSHIP
can raise more funds
than sole
proprietorship
borrowing power enhanced by
more powers
more available brain power and
managerial skill
income included and taxed
on partners personal tax
return
CORPORATION
owners have limited
liability
can achieve large size via
sale of ownership (stock)
ownership is transferrable
long life of firm
can hire professional managers
Has better access to financing
Can offer attractive retirement
plans
Table 1.1b WEAKNESSES OF THE COMMON LEGAL
FORMS OF BUSINESS ORGANIZATION
SOLE
PROPRIETORSHIP
Owner has unlimited liability
total wealth can be taken to
satisfy debts
limited fund-raising power
tends to inhibit growth
proprietor must be jack-of-
all trades
Difficult to give employees run
career opportunities
lacks continuity when
proprietor dies
PARTNERSHIP
Owners have unlimited
liability
Partnership is dissolved
when a partner dies
Difficult to liquidate or
transfer partnership
CORPORATION
taxes generally higher,
dividends are taxed at a
maximum of 15%
more expensive to organize
Subject to greater
government regulation
Lacks secrecy
(stockholders must receive
FS)
Stockholders
Figure 1.1 CORPORATE ORGANIZATION
elect
Board of Directors
hires
President (CEO)
VP Human
Resource
VP Manufacturing
VP Finance
(CFO)
VP Marketing
VP Info
Resources
Treasurer Controller
Financial
Planning
& Fund
Raising
Manager
Capital
Expendit
ure
Manager
Cash
Manager
Credit
Manager
Pension
Fund
Manager
FOREX
Manager
Corporate
Accounting
Manager
Tax
Manager
Financial
Accounting
Manager
Cost
Accounting
Manager
OWNERS
MANAGERS
Why study Managerial Finance?
Because most business
decisions are measured in
financial terms!!!!
FINANCIAL MANAGER
CAREER OPPORTUNITIES IN MANAGERIAL FINANCE
Prepares financial plans and budgets
Financial forecasting, financial comparisons, working
closely with accounting.
FINANCIAL ANALYST
Involved in the financial aspects of implementing
approved investments.
CAPITAL EXPENDITURE
MANAGER
Arranges financing for approved asset investments.
Coordinates consultants, investment bankers, and
legal counsel.
PROJECT FINANCE
MANAGER
CAREER OPPORTUNITIES IN MANAGERIAL FINANCE
Maintains and controls the firms daily
cash balance.
CASH MANAGER
Administers credit policy by evaluating
credit application, extending credit,
and monitoring and collecting A/R.
CREDIT ANALYST/
MANAGER
Oversees the assets and liabilities of
the employees pension fund.
PENSION FUND
MANAGER
CAREER OPPORTUNITIES IN MANAGERIAL FINANCE
Manages specific foreign and the
firms exposure to fluctuations.
FOREIGN EXCHANGE
MANAGER
1.2 THE MANAGERIAL FINANCE FUNCTION
VP FINANCE (CFO)
PRESIDENT
TREASURER
Financial Manager
external
CONTROLLER
Chief Accountant
internal
RELATIONSHIP OF FINANCIAL MANAGEMENT TO
OTHER FIELDS OF BUSINESS
ECONOMICS efficient allocation of scarce means of
production toward the satisfaction of human needs and
wants.

Marginal
cost-benefit
analysis
- The financial
decisions should be
made and actions
taken only when
the added benefits
exceed the added
costs.








Example:
Decide whether to replace the old with a
new computer using the following data:

NEW COMPUTER purchase would require
cash outlay of $80,000 but will have benefits
of $100,000.

OLD COMPUTER can be sold to net of
$28,000 and will have benefits of $35,000 if
still be used.









Benefits with new computer $ 100,000
Less: Benefit with old computer 35,000
(1) Marginal (added) benefits $ 65,000
Cost of new computer $ 80,000
Less: Proceeds from sale of old computer 28,000
(2) Marginal (added) costs 52,000
Net benefit [(1) (2)] $ 13,000
Applying the marginal cost-benefit analysis..
Since the marginal added
benefits of $65,000 exceed the
marginal added costs of
$52,000, the firm should
purchase the new computer
and experience a net benefit of
$13,000!!!!!
ACCOUNTING a service activity whose function is to provide
quantitative information, primarily financial in nature, about
economic entities, that is to be useful in making economic
decisions.
Basic
difference
between
FINANCE and
ACCOUNTING
Emphasis
on CASH
FLOW
accrual basis in accounting.
- recognizes revenue when earned and
expenses when incurred.
cash basis in financial management.
- recognizes revenue and expenses only
with respect to inflows and outflows of cash.
DECISION
MAKING
In accounting, accountants focus on
collection and presentation of financial data.
In financial management, financial managers
evaluate accounting statements, develop data,
and make decisions on the basis of their
assessment of the associated returns and risks.
Figure 1.2 PRIMARY ACTIVITIES OF A FINACIAL
MANAGER
Current
Asset
Current
Liabilities
Fixed
Asset
Long-
Term
Funds
BALANCE SHEET
Making
Investment
Decisions
Making
Financing
Decisions
1.3 GOAL OF THE FIRM
We need to maximize profit
by means of increasing the
earnings per share!!!
Total earnings available to common stockholders
number of common shares outstanding
No way! Our objective should be to
maximize shareholder wealth !!!
What should
I do?
Sample case:
A financial manager is choosing between two investments with expected
earnings per share as shown below:

Earnings per share
Investment Year 1 Year 2 Year 3 Total
ROTOR $ 1.40 $ 1.00 $ 0.40 $ 2.80
VALVE 0.60 1.00 1.40 3.00
If answered on the
point of view of profit
maximization the
choice would be
VALVE.
Yahoo!!!
My answer
is correct!
But if answered on
the point of view of
shareholder wealth
maximization the
choice would be
ROTOR.
Of course! !!
I have the
correct
answer!
Hey!!! Im the
finance manager
here! Now Im
confused! Which is
correct?...
Is profit maximization a reasonable goal?
No! It fails for the following reasons: (1) timing
of returns, (2) cash flows available to
stockholders, and (3) risk.
TIMING. The receipt of funds sooner than later is
preferred. Though the total earnings of ROTOR is
lower than VALVE, still, ROTOR has larger returns in
year 1 and therefore could be reinvested to provide
greater future earnings.
CASH FLOWS. Earnings or Profits does
not necessarily means cash inflow to
stockholders.
RISK. Actual outcomes may
differ from those expected.
There must be a trade-off
between return (cash flow)
and risk.
Therefore, I should definitely
invest in ROTOR using the
point of view of shareholder
wealth maximization!!!
The correct answer should be shareholder
wealth maximization.

Financial managers should accept only those actions that are expected to increase share price
Figure 1.3
Share Price
Maximization
Financial
Managers
Financial
Decision
Alternatives
Return?
Risk?
Increase
the Share
Price?
Yes
Accept
No
Reject
Other concerns of financial management:
1. Focus also on the stakeholders wealth.
employees, customers,
suppliers, creditors, owners,
and others who have a
direct economic link to the
firm.
2. Establish good corporate governance
The system used to direct and control a
corporation. Defines the rights and
responsibilities of key corporate
participants, decision making procedures,
and the way in which the firm will set,
achieve, and monitor its objectives.

The boards first responsibility is to the
shareholders with broad classes of:
a. Individual investors who buy
relatively small quantities of shares.
b. Institutional investors investment
professionals such as insurance
companies, mutual funds, and
pension funds, that are paid to
manage other peoples money.

has greater
influence over
corporate
governance
Issues arose from numerous corporate misdeeds:
(1) false disclosures in financial reporting and other
information releases
(2) undisclosed conflicts of interests
[between corporations and their analysts, auditors, and attorneys and
between corporate directors, officers and shareholders.]




SARBANES-
OXLEY ACT
OF 2002
(SOX)
An act aimed at eliminating
corporate disclosure and conflict of
interest problems.
Other concerns of financial management:
3. Considering the role of ethics.
Standards of conduct or
moral judgment.
Example of cases wherein the ethics became a major media issue:

- when energy company Enron Corps key executives failed to
disclose to employees and shareholders of its bankruptcy.

- when auditing firm KPMG failed in their audit work with a
company Lernout and Hauspie Speech Products that forced the
auditing firm to pay $115 million to settle a shareholder lawsuit.
Develop an effective ethics
program
Other concerns of financial management:
4. Solving the agency issue.
There must be a clear cut
indication of separation of
the owners and
managers
The Agency Problem is the likelihood that managers may place
personal goals ahead of corporate goals.
Factors that serve to prevent or minimize agency problems:
Market Forces
- some large institutional
investors tend to exercise
their voting rights to
influence the
management.
Agency Costs
- costs borne by
stockholders to
maintain a governance
structure
Agency costs explained
Structure management
compensation
the objective
was to give
managers
incentives to act
in the best
interests of the
owners.
Incentive plans tend to tie
management compensations to share
price; the most popular incentive plan
involves the grant of stock options.
Performance plan plans tie
management to measures such as EPS,
growth in EPS, and other ratios of
return.
Cash bonuses cash paid to
management for achieving certain
performance goals.
1.4 FINANCIAL INSTITUTIONS AND MARKETS
FINANCIAL INSTITUTIONS
FINANCIAL MARKETS
serve as intermediaries
by channeling the
savings of individuals,
businesses, and
governments into
loans or investments
forums in which
suppliers of funds and
demanders of funds
can transact business
directly.
Money
market
Capital
market
Money Market vs. Capital Market
marketable
securities
bonds
money market
stocks
capital market
SHORT-TERM DEBT
INSTRUMENTS
LONG-TERM DEBT
INSTRUMENTS
HOW TO RAISE MONEY THROUGH THE
FINANCIAL MARKETS?...
Securities Exchanges provide the marketplace in which firms can raise funds through
the sale of new securities and purchases of securities can easily resell them when
necessary. The two key types of securities exchanges are:
ORGANIZED SECURITIES
EXCHANGE tangible
organizations that act as
secondary markets where
outstanding securities are
resold.
Example: New York Stock
Exchange
OVER-THE-COUNTER
EXCHANGES an intangible
market for the purchase and sale of
securities not listed by the
organized exchanges.
OTC traders, known as dealers, are
linked with the purchasers and
sellers of securities through the
National Association of Securities
Dealers Automated Quotation
(Nasdaq) system.